Option Investor
Trader's Corner

Still as Much Art as Science

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Today's traders are lucky. Charting programs allow them to reposition trendlines by trial and error until they find the best fit. They can decide whether that best fit runs along all candle shadows or just along the candle bodies.

In the past, such experimentation required penciling in trendlines, erasing them, and trying again, hoping that the eraser didn't wear a hole in the chart before the best fit was determined.

Whether penciling in lines or using a modern charting program, determining the right trendline is still often as much art as science.

Remember that my articles are usually prepared in advance, and so do not reflect current prices.

Annotated Weekly Chart of the SPX:

Similar questions could be asked about trendlines that defined resistance from 2004 to the end of August of 2006.

While the supporting trendlines were closely aligned at the end of August, they will diverge further as time passed. The question as to which is the most valid trendline might become more important if the current pattern is extended into mid-spring of next year, for example.

Making such decisions is a necessary task in any traders' repertoire. Whether traders' preferred options plays are limited to buying calls and puts that take advantage of a directional move or are more complicated combination strategies that seek to define a likely range, traders need to know where support and resistance might lie. Last week's Trader's Corner article discussed using moving averages to determine support and resistance levels, and this week's will continue the series, discussing trendlines.

Last week's article determined that using a corroborating indicator helps traders determine when a moving average serves as support or resistance during a particular market period, honing in on the best average to use. The same tactic works with trendlines.

Annotated Weekly Chart of the SPX:

Not all trendlines climb or descend, of course. Horizontal lines sometimes coincide with historical support or resistance. Determining where such a horizontal trendline should be placed sometimes requires even more art.

Annotated Daily Chart of Goldman Sachs

Using RSI or another indicator to clarify which horizontal trendline is most relevant doesn't appear to work as well with these horizontal trendlines.

Annotated Daily Chart of Goldman Sachs

A snapped Fibonacci bracket that encompasses the rally off last year's low also doesn't clarify matters.

Annotated Daily Chart of Goldman Sachs:

Here's a case where a trader's art and experience must guide the choices. My personal choice would be to use the red lines as horizontal trendlines. I tend to prefer a best-fit trendline hit most often by opens, closes, highs or lows. Each of those red horizontal lines has been pierced, but there has been only one minimal close outside them since May, and that close occurred with a strong spring that almost made it back above the red line. Therefore, it seems to me that a significant close outside those red lines or a close outside them for two to three days will mark a change in trend that may be significant. A quick reversal back inside the zone they define would alert me that either my original trendline assumptions had been wrong or that stops had just been run before the real move, but until then, that would be my choice.

Other traders might make different choices. That's the art behind determining trendline support or resistance.

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